Market failures handout - Market Failures Handout Market...

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Unformatted text preview: Market Failures Handout Market failures: 1. Imperfect competition 2. Externalities 3. Public goods 4. Asymmetric information 5. Individuals fail to act in their own best‐interest Before advocating a policy, ask yourself: What market failure is the policy addressing? ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ An externality (external effect) arises when a person engages in an activity that influences the well‐ being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse, it’s called a negative externality. Ex.: car exhaust. If the impact on the bystander is beneficial, it’s called a positive externality. Ex.: flower display. Possible solutions to the externality problem: (1) Moral codes and social sanctions (2) Private charities (e.g., Sierra Club) (3) Government regulation (4) Taxes and subsidies (5) Private contracts (requires enforced property rights): The Coase Theorem (6) Tradable permits (requires enforced property rights) The Coase Theorem: When trade in an externality is possible and there are no transactions costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ A good is excludable if people can be prevented from using it. A good is rival if one person’s use of the good diminishes another person’s enjoyment of it. Rival? YES NO private goods club goods (natural monopolies) YES (ice cream cones, (fire protection, cable TV, Excludeable? congested toll roads) uncongested toll roads) common resources (externalities) public goods NO (fish in the ocean, the environment, (national defense, knowledge, public congested nontoll roads) parks, uncongested nontoll roads) ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ An especially important case of imperfect information is asymmetric information, where one player knows more than another player. Two main kinds of asymmetric information: (1) Hidden information (a.k.a. adverse selection). Adverse selection arises when one person knows more about the attributes of a good than another (and, as a result, the uninformed person runs the risk of being sold a good of low quality). Ex.: market for lemons. (2) Hidden action (a.k.a. moral hazard, principal‐agent problem, agency problem). Moral hazard is when a principal’s payoff depends on an agent’s actions, and it is impossible to write a contract on the agent’s actions (perhaps because unobservable). Ex.: “too big to fail.” A possible solution to the adverse selection problem is (costly) signaling: taking an action with the purpose of conveying information. ...
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